IS JAPAN SIGNALING AN END TO THE “END OF THE WORLD” TRADE?

Takeaway:If the crashing yen and tumbling JGB market are signaling anything to us, it’s that the end-of-the-world trade appears to be ending.

SUMMARY BULLETS:

JGBs are fast falling in price on a combination of improved domestic and global growth expectations and a parabolic increase in domestic inflation expectations. Credit risk is not a meaningful factor in the recent backup in JGB rates.

If the crashing yen and tumbling JGB market are signaling anything to us beyond Japan, it’s that the end-of-the-world trade appears to be ending. To varying degrees, these signals are being confirmed across the US Treasury bond market and in the price of gold, which are also breaking down/broken down quantitatively.

Could we see a 1994-style or 2003-style backup in super-sovereign interest rates over the next 12-18 months? Absolutely – especially if you believe in the reflexive @HedgeyeMacro bull thesis for the US economy: #StrongDollar = #ConsumptionTaxCut; #HouseholdFormationAcceleration; #BabyMakingBacklog; #ParabolicHousingMarket; and #LaborMarketImprovement.

The key question investors should be asking as it pertains to their US equity exposure is whether today’s setup is more akin to 1994 (SPX down -1.5%) or 2003 (SPX up +26.4%). The Weimar Nikkei 225 doesn’t really care all that much, as it appreciated +13.2% in 1994 and +24.5% in 2003 in spite of the commensurate backups in JGB rates.

It would be an understatement to say that JGB yields are backing up across the curve. From their respective YTD lows (2/12 for 2Y; 4/4 for 10Y and 4/5 for 30Y), nominal JGB yields have backed up +11bps, +41bps and +79bps on the 2Y, 10Y and 30Y tenors, respectively. Looking to the 2Y and 10Y tenors, specifically, the JGB market’s pricing in of the regime change at the BOJ (unprecedented monetary base expansion; longer maturity purchases) has now been completely unwound.

Looking to the 10Y JGB tenor specifically, the recent selloff has some investors believing that the time is now as it relates to a JGB market swoon. Irrespective of the fact that a lot of those same investors have been inappropriately making that call for years, we are finally inclined to side with them at the current juncture as yields have finally broken out above our long-term TAIL line of resistance (now support).

From our macro team’s perspective, there are three primary reasons why a super-sovereign debt security like a JGB, UST or Bund would fall in price:

Expectations of #GrowthAccelerating

Expectations of #InflationAccelerating

Credit risk rising

Below, we explore all three from Japan’s perspective and offer up our thoughts on what may be the beginning of the end for the #EOW (end-of-world) trade (i.e. long USTs, JGBs, JPY and Gold).

#GrowthAccelerating?

As we mentioned in a recent research note, the trend in Japanese economic data is finally starting to improve – which is to be expected given that the country is attempting to confirm an escape from its third recession in the past five years. From an international perspective, we continue to sing the praises of our non-consensus bullish thesis on US economic growth. #StrongDollar commodity deflation has proven to be a marvelous offset to analytically-loose fiscal policy fears (sequestration and tax-hikes) in the YTD.

Jumping back to Japan specifically, BOJ Governor Haruhiko Kuroda today rejected an opposition-party member's argument that the recent surge in the Japanese equity market is out of line with Japan's real economy, stating: "At this moment I do not think they are in a bubble."

As previously mentioned, JGB yields are starting to back up in aggressive fashion – much like they did back in 1994 and 2003, alongside a commensurate backup in yields across the US Treasury curve. Both were positive signals for Japanese equities then and the current signal is likely indicative of the asset allocation shift we have been calling for in recent months.

To that tune, only 6.8% of Japanese household financial assets are held in equities vs. 14.4% for the Eurozone and 32.8% for the US. Clearly there’s lots of hay to bale for “Mrs. Watanabe” and her 55.2% allocation to currency and deposits – which then are funneled back into JGBs via bank intermediation.

This circuitous method of sovereign financing has saddled roughly one-fourth of Japanese banks balance sheets with low-yielding JGBs – exposing them to a meaningful degree of interest rate risk. Per a 2H12 report out of the BOJ:

Japanese banks would face a total of 6.7 trillion yen ($84 billion) in losses if rates rise by +100bps;

Losses at major banks would total 3.7 trillion yen, while those at regional banks would amount to 3 trillion yen; and

The average maturity of Japanese debt held by large lenders is about 2.5 years and about 4 years for regional banks.

Of course, Japanese banks would love for yields to back up in a controlled manner (i.e. at a rate where credit expansion can occur to help offset marked-to-market losses on existing holdings). The average interest rate on new loans across the Japanese banking system has consistently tracked the 10Y JGB yield to new all-time lows over the past 20 years, compressing banks’ NIMs and eroding banks’ earnings power in the process.

#InflationAccelerating?

You know where we stand on Policies To Inflate and the likely unintended consequences of Japan burning its currency at the stake, so there’s no sense in wasting anyone’s time rehashing that here. What is worth pointing out, however, is the fact that Japanese breakevens have gone absolutely parabolic, closing at 1.84% on the 5Y tenor. The JGB market is taking Abenomics quite seriously.

On the recently released APR Consumer Confidence report (which ticked down -0.3ppts MoM to 44.5), the percentage of Japanese households that expected consumer prices to rise increased +370bps MoM to 82.8% – good for a ~4.5yr high.

#CreditRiskAccelerating?

This is probably the least likely cause of the recent plunge in JGB prices. At this point, reminding investors of Japan’s bleak sovereign fiscal situation is not worth the time it would take to type it. That being said, however, the Japanese sovereign itself is not immune to interest rate risk – particularly if the aforementioned backup in rates is being driven by inflation, rather than economic growth.

It’s worth noting that debt service already consumes 47.2% of tax and fee revenue in Japan, which also equates to about 4.6% of nominal GDP. The sovereign interest expense alone accounts for 44.5% of debt service and 1.8% of nominal GDP – and that’s on a weighted average cost of capital of 1.2%.

From a credit market perspective, buyers and sellers of CDS contracts on the Japanese sovereign continue to see waning risk of a sovereign default. That’s bad news for crisis sellers across the investment landscape. Again, you won’t ever see us #timestamp a call on sovereign credit risk without some confirming evidence from the credit market itself – of which there is none in Japan at the current juncture.

All told, we see limited signs that the recent backup in JGB yields is being driven by credit risk. The only new news on the Japanese fiscal policy front worth mentioning is the Ministry of Finance’s decision to punt the announcement of its medium-term fiscal reconstruction plan to the SEP G-20 Summit in Russia, originally scheduled for next month’s G-8 meeting in the UK.

That’s an extremely loose catalyst for the credit risk camp to hang their hats on here. In fact, the only bearish credit risk scenario we can piece together from that is the fact that it will come after the Upper House elections in late-JUL. By then the LDP will have a likely majority there as well, giving it full reign to enact whatever fiscal policies it pleases – including kicking the can down the road on the first VAT hike, which is scheduled to occur early next year. Recall that former DPJ Prime Minster Yoshihiko Noda staked his political career on getting that piece of legislation ratified.

#EOW Ending?

If the crashing yen and tumbling JGB market are signaling anything to us, it’s that the end-of-the-world trade appears to be ending. To varying degrees, these signals are being confirmed across the US Treasury bond market and in the price of gold, which are also breaking down/broken down quantitatively.

Could we see a 1994-style or 2003-style backup in super-sovereign interest rates over the next 12-18 months? Absolutely – especially if you believe in the reflexive @HedgeyeMacro bull thesis for the US economy: #StrongDollar = #ConsumptionTaxCut; #HouseholdFormationAcceleration; #BabyMakingBacklog; #ParabolicHousingMarket; and #LaborMarketImprovement.

The key question investors should be asking as it pertains to their US equity exposure is whether today’s setup is more akin to 1994 (SPX down -1.5%) or 2003 (SPX up +26.4%). The Weimar Nikkei 225 doesn’t really care all that much, as it appreciated +13.2% in 1994 and +24.5% in 2003 in spite of the commensurate backups in JGB rates.

Darius Dale

Senior Analyst

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05/15/13 03:23 PM EDT

CHART DU JOUR: MASSIVE INCREASE

MPEL’s Mass push has been an overwhelming success

Mass revenue per table still climbing at a fast rate for all operators with the exception of capacity constrained SJM

MPEL’s Mass business has come a long way in 2 years and the operator is firmly entrenched as the market leader in terms of productivity and growth (along with Galaxy on the growth front)

Remind us again why MPEL deserves such a valuation discount? It can’t be due to operational prowess. EBITDA is not shown here but MPEL is also the market leader in same-store EBITDA growth over the same period.

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05/15/13 01:33 PM EDT

PF - No New Holes to Poke in a Solid Quarter

The issues with PF are well known – crappy categories and sluggish top line sitting atop a highly-levered balance sheet. As we mentioned previously, the company does have some margin levers to pull in ’13, which may be helped over time by lower commodity costs. All of these factors came together in what was a pretty solid first quarter out of the IPO gate.

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What we liked:

EPS of $0.34, ahead of somewhat unreliable consensus estimate

A substantial improvement in gross margins (+290 bps) against an easy comparison – this is where we see the most opportunity for progress for the company in 2013, as per our prior piece on the name

Excellent FCF quarter ($49.5 million or $0.42 per share versus $20.3 million in the year ago)

Next quarter’s comparisons remain unchallenging, so we could likely see a repeat of the margin performance posted in Q1

New dividend (as of last night) - $0.72 annually

What we didn’t like:

Lackluster sales growth in Birds Eye Frozen (+0.7%) and Duncan Hines (2.3%) even with volumes flattered by the timing of Easter

Inventories increased 2.6%, outpacing sales growth

Bottom line, with the newly instituted dividend, downside in the name is probably limited to $22/$23 per share (where the yield with the annual $0.72 dividend creeps above 3%). Further, with another quarter of easy margins comparisons, there is likely some further upside in the shares despite what we see as full valuation.

Call with questions,

Rob﻿

Robert Campagnino

Managing Director

HEDGEYE RISK MANAGEMENT, LLC

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Matt Hedrick

Senior Analyst

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Early Look

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MCDONALD'S MENU "INNOVATION"

This note was originally published May 14, 2013 at 11:15 in Restaurants

A revival of trends in the U.S. is a key pillar of the bull case on MCD. In light of the “menu innovation” year-to-date, we feel confident standing by our bear case.

A few months ago we wrote that McDonald’s was going to abandon its Angus burger and now we read that a new line of quarter pounders is replacing the product in an effort to deliver the top-line growth needed to meet expectations.

Bull Case Crumbling

One bullish analyst on the Street has suggested that the company needs a “hero-like lifting” from U.S. consumers as the global macro picture looks mixed. The expectations that comps will reflate seems stretched, given our view on MCD’s pricing flexibility, and we expect U.S. comps to fall short of the level needed to carry the stock higher. We believe the most likely outcome is that the fundamentals of McDonald’s business continue to suggest a lowering of EPS expectations for 2013.

Innovation?

The recent news that McDonald's is adding to its Quarter Pounder line up has spurred a lot of dialogue among the investment community. These additions are not quite as striking as past innovations but are unusual in that they fall on a generally stable part of the McDonald's menu. Greg Watson, McDonald’s USA SVP-Menu Innovation Team said, “we haven’t touched the Quarter Pounder since its inception 40 years ago. We think this is a great way to bring new news to the brand.”

Six months ago, the question on investors’ minds was, “what menu innovation will MCD push through to grow the top line?” Now, we know: premium wraps and a new line of quarter pounders. In light of this, we remain confident in our bearish thesis.

From late May or early June, there will be three new Quarter Pounder varieties offered at McDonald’s with national advertising starting in mid-June.

MCD is going to take most popular condiments from the Angus line and put them on the Quarter Pounder brand

The company is creating a third new flavor—Habanero Ranch with white Cheddar, bacon, lettuce, tomato, and habanero ranch sauce tested

The new quarter pounders will be served on bakery-style buns

What Does the Failure of The Angus Burger Tell Us?

It is difficult to know why the offering failed. It could have been too expensive for the McDonald’s customer or the construct of the burger may have been unpopular. If either of these speculations is true, it could suggest that the new quarter pounder offerings – drawing from the Angus ingredients – are unlikely to resonate or, if pricing was the issue, that McDonald’s has limited pricing flexibility. Neither scenario would be positive for shareholders.

The early August release of July sales will be the day when we gain the most significant insight into the effectiveness of this year’s menu changes. We continue to believe that the Street’s numbers are too high.

Overbought (finally): SP500 Levels, Refreshed

Takeaway:The market is overbought and it’s a safer place to cut gross long exposure and/or start tightening your net exposure than it was last week.

POSITION:9 LONGS, 6 SHORTS @Hedgeye

Finally, anywhere north of 1657, the SP500 is immediate-term TRADE overbought. I have been waiting to send you this overbought email all week – but my machine didn’t give me the explicit signal until today. I listen to my wife, and my machine.

This doesn’t mean I am trying to call a top. This simply means what it says – the market is overbought and it’s a safer place to cut gross long exposure and/or start tightening your net exposure than it was last week.

The fundament bull case of #StrongDollar hasn’t been better obviously (USD is at its YTD high here intraday), but it too is immediate-term TRADE overbought. SPX vs USD has a positive correlation on our TREND duration of +0.81.

Across our core risk management durations, here are the lines that matter to me most:

Immediate-term TRADE overbought = 1657

Immediate-term TRADE support = 1629

Intermediate-term TREND support = 1545

In other words, we are up on a rope. Sell some high – buyem back on red, and keep doing more of what’s been working.

KM

Keith R. McCullough Chief Executive Officer

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05/15/13 12:16 PM EDT

DF – Quick Update on When Issued Trading

WWAV shares began trading “when issued” this morning, and since you don’t need a borrow on when issued shares, investors are buying shares of DF and simply selling shares of WWAV/A and WWAV/B (when issued) – both those securities are now trading at a substantial discount to WWAV regular way (WWAV/B is trading nearly a $1 below WWAV).

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There is also significant volume in the DF when issued (trading at $9.15), but keep in mind that value includes the remaining 19.9% interest in WWAV that DF will seek to monetize over the next 18 months.

Using the most aggressive value of the DF stub obtained by looking at all these moving parts – DF regular way less the value of WWAV/B, the stub is trading at approximately $6 per share, which still only equates to 5.1x EV/EBITDA for the fluid milk business, so there is still plenty of meat on the bone.

For investors that are able to trade when issued securities (not everyone), purchasing DF when issued makes a great deal of sense to us at this point. Interestingly, while acknowledging that WWAV is a difficult borrow, investors so inclined and able to do so could by WWAV/B when issued and short WWAV regular way – the two values are nearly a $1 apart and that spread will move to zero over the next week.

-Rob

Robert Campagnino

Managing Director

HEDGEYE RISK MANAGEMENT, LLC

E:

P:

Matt Hedrick

Senior Analyst

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